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What the recent market move means for European credit

Not a cycle reversal. We qualify the recent price actions as corrections, not as a cycle reversal.This position is mainly supported by past performance: profit taking is appealing when volatility increases.

Fundamentals. Credit fundamentals remain strong. We are at a stage in the economic cycle that looks generally rather beneficial for companies. In Europe in particular, the financial windfall has not been aiming at increasing leverage and default rates are expected to remain low.

Implications for investors in European credit markets. We think it is appropriate to maintain a low beta stance in Euro high yield while in investment-grade credit we favour banks and high beta.

Liquidity. Market liquidity should be watched closely at this stage. In terms of investment approach, we view it as appropriate to maintain liquidity buffers in portfolios, based on the potential that risk aversion could rise again in the market. Liquidity can be tactically repositioned in case of corrections.

Embrace an active approach. This correction opens a new phase in the market with higher volatility ahead. Flexibility and security selection will remain key.

How do you asses the recent move in credit markets: a correction or a cycle reversal?

Eric BRARD: The corrections in the credit markets (Europe and the US) have the same roots as those which affected the equity markets: the broken circle "low growth/low inflation/low rates/ pervasive Central Banks (CB)" entails a repricing of the whole financial assets spectrum. Stronger growth, with now rising inflation has resulted in higher rates and CB starting to tighten policy. Hence, the price correction of assets that had benefited most from the years of risk blindness and cash abundance.

That said, we qualify these new price actions as corrections, not as a cycle reversal. The causes are clear: stronger growth and higher inflation (but not hyperinflation).

The prolonged period of low interest rates and abundant liquidity allowed corporates to extend the average maturity of their debt and to fine tune capital structures and balance sheets in companies’ best interests

What is you view on the European credit market at the current stage of the cycle?

Eric BRARD: We are at a stage in the economic cycle which is generally rather beneficial for companies.

The prolonged period of low interest rates and abundant liquidity experienced in recent years has allowed corporates in all sectors to extend the average maturity of their debt and to fine tune capital structures and balance sheets to support companies’ performance.

In Europe in particular, this financial windfall has not been aimed at increasing leverage, neither by increasing dividends nor via share buybacks. The latter remains globally well below the pre-2007 period. This is observed within the investment-grade segment as well as in high yield. Default rates are expected to remain low (1.2% over the next 12 months).

Our point is that this current correction is mainly the result of significant past performance: profit taking is appealing when volatility is rising. This position is supported by data on investor behaviour regarding outflows (in both Euro and US high yield, partly driven by ETF).

A shift in volumes had already been spotted in 2017, but these were absorbed without any disruption. Substantiating that argument, the Euro high yield secondary market is supported by limited net supply, as the loan market is currently more attractive to issuers.

We expect higher volatility in credit markets which will require a change of focus and that investors adapt quickly to changing conditions.”

From a Euro fixed income perspective, what are the major investment implications?

Marie-Anne ALLIER: In terms of portfolio management, this environment drives the following investment implications. In Euro high yield, we think it is appropriate to maintain a low beta stance. We remain constructive, as both macro factors and fundamentals continue to be supportive compared to last year. Moving into 2018, in particular the focus has been more on specific risks within this asset class.

In Euro high grade, we think it is appropriate to reduce the overall beta of a portfolio as well while favouring banks (positively impacted by better growth, higher yields and steeper curves) and also selectively some high beta (that has proven to be more resilient in a market correction phase). We also believe it is time to become more flexible with regard to repositioning cash in case of corrections.

Do you think that opportunities could arise in this credit market environment?

Marie-Anne ALLIER: The current situation is viewed as a fair correction. Due to the shift in monetary policies, volatility will be much higher than the average level experienced over the recent past. This situation will require a change of mindset and investors will need to adapt to changes in global financial markets dynamics. All in all, this correction means lower valuation and higher volatility, but the environment could lead to opportunities for investors embracing an active management approach.